Among Opposing Forces*

Introduction

It's a pleasure to speak to you today. Let me start by thanking the McLean County Chamber of Commerce for inviting me, and Ryan Whitehouse who helped arrange my visit here today.

The U.S. economy currently faces a number of difficult challenges: These include weakness in the housing market, continued financial market turmoil, and the potential for more persistent inflation emanating from the surge in food and commodity prices. The confluence of these and other factors have added layers of complexity to the management of monetary policy. I recently returned from our regular policy meeting in Washington, where, after considering all of the issues, the Federal Open Market Committee decided to leave the federal funds rate unchanged at 2 percent. Today, I'd like to share with you some of the thinking that shapes my views about policy—namely, my thoughts on the near- and medium-term prospects for growth and inflation, the state of financial markets, and the role of monetary policy in the current environment. Before we begin, though, let me note that the views I express today are my own and are not necessarily shared by my colleagues on the Federal Open Market Committee.

Current Economic Situation

We are in the midst of a sharp contraction in housing markets that began in 2006. Delinquency rates for residential real estate loans have more than doubled since the troubles began; single-family housing starts are down about two-thirds; and house prices have fallen about 16 percent from their peak, as measured by the Case—Shiller home price index. The inventory of homes for sale remains high. On average, declines in residential investment have subtracted a bit more than 1 percentage point per quarter from real GDP growth over the past two years. Although it is too early to say we are nearing the bottom of the housing cycle, in the most recent quarter residential investment reduced real GDP growth by a smaller magnitude—about two-thirds of a percentage point. As any economist will tell you, "less bad" can be a first step toward improvement.

The downward adjustment in housing activity has been associated with a doubling in the fraction of nonperforming mortgages since 2006. And over the past year, we have seen the deteriorating performance of mortgages and mortgage-backed securities spill over to other segments of financial markets. Market participants have reassessed the risk profiles of other similarly structured assets, and prices of these securities have declined as well. The re-pricing process has had a significant impact on the liquidity and capital positions of financial institutions. Declines in asset prices and the increase in nonperforming loans have eroded banks' capital positions. In response, many banks have taken steps to raise capital by issuing new equity, reducing dividend payments, and by selling certain assets. But, to the extent that capital ratios have continued to be strained, financial institutions have also restricted lending and worked to reduce the riskiness of their portfolios by tightening credit terms and standards. As a result, credit is now more costly and difficult to obtain for many kinds of household and business borrowing.

Financial turmoil and weakening housing markets are not the only factors weighing on economic activity. Over the past year, we also have experienced substantial increases in food and energy prices. These have reduced the purchasing power of households and increased firms' costs of materials, which have also weighed on economic growth. Labor markets have been weak. Payroll employment has declined steadily over the first seven months of this year, with a cumulative loss of over 450 thousand jobs. The largest job losses have been in the construction and manufacturing sectors. Also, the unemployment rate has risen by over a full percentage point during the past year, reaching 5.7 percent in July. Weak labor markets and high consumer prices have held back growth in real income. This, in conjunction with lower housing prices and stock market wealth, has resulted in a noticeable slowing in growth in consumer spending.

There are, however, some positive factors that have helped sustain growth. Declines in the dollar and solid growth by many of our trading partners have led to reductions in our trade deficit, adding substantially to real GDP growth in the second quarter. And, importantly, productivity has increased a healthy 2.8 percent over the past year. Productivity measures how much output the nonfarm business sector can produce for each hour of labor input. It is the fundamental determinant of our ability to generate economic well-being. And our workers and businesses have kept productivity on a solid uptrend by continually developing new productive technologies and new ways to use them.

Indeed, in spite of the economic headwinds we face, real GDP was reported to have increased at an annual rate of 1.9 percent in the second quarter. And recent data suggest that this figure will likely be revised up. However, this did come on the heels of stalled growth at the end of 2007 and a gain of only 0.9 percent in the first quarter of 2008. So, the strong challenges faced by consumers and businesses have reduced growth. But, last January, I was concerned that things could turn out to be much worse.

In addition to the challenges regarding growth, we also are dealing with some unfavorable developments with regard to inflation. At the beginning of the year I expected the inflation picture to be better than it is now. The large increases in food and energy prices that I mentioned earlier have contributed to a 4.1 percent increase in the personal consumption expenditures deflator over the past year. Even core inflation, which excludes both food and energy components, is unsettlingly high, growing 2.3 percent over the year ended in June. Indeed, total inflation has exceeded core inflation pretty consistently for over five years, with both measures above 2 percent during much of this time. I view these persistently high rates of overall and core inflation as important concerns for monetary policy.

Monetary Policy

This brings me to the discussion of how policy is set against the backdrop of such a challenging economic environment. I will begin with a somewhat general perspective. The Fed functions under a dual mandate to foster financial conditions that promote both maximum employment and price stability. Of course, maximum employment must be sustainable. This is usually interpreted as the level of employment that is consistent with a rate of growth that the real economy can maintain over time without leading to an increase in inflationary pressures. We refer to this rate as potential growth. Price stability, as former Chairman Greenspan often said, occurs when inflation does not significantly distort the economic behavior of households or businesses. Price stability does not mean that individual prices do not change. Inflation, in comparison, entails a widespread increase in prices across a broad spectrum of goods and services. I tend to view price stability as core inflation being in the narrow range of 1-1/2 to 2 percent, and the more volatile overall inflation rate also averaging in this neighborhood over longer periods of time.

In practice there are a number of uncertainties and risks that must be carefully weighed when implementing monetary policy. First, policymakers must carefully assess the rate of potential output growth, in large part by estimating the trends in two of its key determinants, productivity and working-age population growth. In recent years, these two factors suggest potential growth is in the range of 2-1/2 to 3 percent. Second, central bankers rely upon data to evaluate where current growth is relative to potential. But the economy is very complex, and we frequently receive conflicting signals. So, it can be difficult to appraise the current situation and project the economy's likely future course. Third, given the assessment of the outlook, the Fed determines if a more accommodative or more restrictive policy is warranted. Evaluating the sources of risk to growth and inflation is also an important part of this decision. Finally, we need to deal with the fact that monetary policy takes time to influence real economic activity and inflation. So, as new information comes in, we are often put in the position of needing to alter course before the full impact of our past policy actions are completely evident.

The current monetary policy environment is even more complicated than usual. If we were using battlefield language to describe our situation, this would be a "three-front conflict." Although real activity is weak, we also are simultaneously experiencing bad news on the inflation front in the form of higher energy and commodity prices. This creates the challenge of facilitating the economy's return toward more favorable growth rates without igniting greater inflationary pressures. The financial turmoil and subsequent tightening of credit conditions add another dimension of difficulty to the problem. I will return to this momentarily. But first let me discuss the economic outlook and how it is shaping policy decisions.

Economic Outlook

Four times a year FOMC participants provide projections for economic growth, the unemployment rate, and the inflation rate for the current and following two years. The most recent projections were submitted at the June FOMC meeting. In general, the Committee's opinion was that growth had been somewhat stronger in the first half of the year than had been originally anticipated. Even so, the consensus view was that the economy would expand slowly over the next several quarters. However, participants continued to see significant downside risks to the forecast for growth. The Committee expected higher near-term headline and core inflation, largely due to the effects of recent high prices for energy and other commodities.

Since these forecasts were made, I think the risks for growth have increased and the risks for inflation remain elevated and a concern. The detail underlying the GDP data and recent numbers for July point to some weakness in growth, particularly after the effects of the recent tax rebates recede. Consumption fell in June after adjusting for inflation. U.S. car and truck production and sales declined significantly further this spring, and the figures for July continued this trend. It is difficult, however, to know how much of the declines reflect cyclical economic weakness and how much are related to structural factors such as higher fuel costs and an unfavorable product mix. Financial markets remain under considerable stress. Labor markets have deteriorated further, and the housing market outlook continues to be uncertain. But inventories are in good shape in most industries. And net exports remain a solid positive, although export growth may taper off some given the softer economic outlook for some of our major trading partners. Despite these risks, as we move forward, I see real GDP growth returning near potential by 2010—somewhere in the range of 2-1/2 to 3 percent.

While energy and commodity prices have moderated somewhat, both headline and core inflation remain high. Some measures of expectations for future inflation remain uncomfortably elevated. As energy prices level out and economic growth remains modest, I think inflation should moderate over the medium term, with PCE headline inflation declining to around 2 percent by 2010. Clearly, this forecast hinges upon developments in energy and commodity prices, as well as containing expectations of future inflation. Both of these present risks to the outlook.

Policy Setting

This environment presents substantial challenges to monetary policy. As you know, since last September, the Fed has lowered the fed funds rate from 5-1/4 to 2 percent. At the time, most forecasters' baseline outlook was for marked sluggishness in real economic activity. But forecasters also recognized the possibility of falling asset prices severely constricting credit and potentially intensifying and spreading the slowdown in the housing market into something much more widespread and acute. The Fed determined it prudent to take preemptive action in response to the unfolding situation. Our 325-basis-point cumulative cut in the funds rate was larger than we otherwise might have done in order to insure against the unlikely event of a severe downturn. That said, even though I think the current 2 percent funds rate is accommodative, it is not especially stimulative. This is because the financial market turmoil has meant that our funds rate reductions have led to less credit expansion to households and businesses than typically would be the case.

Indeed, it has become increasingly clear to me that the fed funds rate alone is neither an adequate nor even an entirely appropriate tool for addressing instability in the financial markets. Further reductions in the fed funds rate could help provide additional liquidity to financial markets as a whole, but not necessarily to the most distressed portions of the market. And, in principle, if pushed too far, excess policy accommodation over an extended period of time would risk igniting inflation expectations. However, the ongoing challenges in financial markets indicate the continued need for substantial liquidity in order to facilitate their functioning and to ensure adequate funding for creditworthy businesses and households.

Accordingly, the Federal Reserve has created several special lending facilities aimed at providing financial markets with liquidity and promoting orderly financial adjustments. Since last August, we have introduced the Term Discount Window, the Term Auction Facility, the Term Securities Lending Facility, the Term Options Program, and the Primary Dealer Credit Facility. Collectively these innovations are designed to increase market liquidity by lengthening Federal Reserve lending terms, by reducing the cost of borrowing relative to the fed funds rate, by expanding the range of eligible counterparties, and by enlarging the pool of eligible collateral. I should note that in order to provide the Fed with a cushion against credit risk, the value of collateral backing the loans at these facilities is set at a discount from the latest market prices for the pledged assets. These facilities have helped stabilize short-term credit markets somewhat and have injected much needed liquidity into the financial system. The success of these facilities—which, I would like to emphasize, should be measured against the list of feasible outcomes they can achieve—should help financial markets work through their problems over time.

At our meeting this past week the Fed left the benchmark fed funds rate unchanged at 2 percent. Of course, we policymakers must continuously reevaluate our policies to reflect current and forecasted conditions, and to ensure our assessments of risks are aligned to meet our long-term policy objectives. As I just discussed, from the perspective of last January, the real economy has performed better than was predicted. And while the second half of 2008 will likely be extremely sluggish, the risk of a severe slowdown seems less likely today than predicted at the beginning of the year. In addition, as I also noted, there is clearly an increased risk to inflation. Headline inflation has exceeded core inflation for an extended period of time, and even the latter has been above 2 percent for some time.

In evaluating inflation risks, we must be concerned about energy and food prices being passed through to core inflation. We run the risk of persistent widespread price increases being built into the expectations of households and businesses, and thus producing persistently higher bases for both inflation measures. Some have taken comfort in the fact that inflation has not yet been built into wage growth as evidence that inflationary expectations have not risen. But I am less sanguine because research indicates that by the time we have statistical confirmation that wages are increasing at rates higher than the rate of growth of productivity, a persistent rise in inflation most likely would already be in train.

There are clearly risks to the inflation outlook if expectations do not remain grounded. Any increase in inflation expectations would pose a risk to achieving our dual goals of price stability and maximum sustainable growth.

Conclusion

The current economic landscape poses a three-front conflict for policymakers: sluggish economic conditions with depressed housing and auto markets, rising inflation risks with high oil and commodity prices, and financial distress that is restraining credit growth. To date, relatively accommodative monetary policy has taken out insurance against downside risks of disorderly financial adjustment turning into a severe economic downturn. But rising inflation risks at a time of economic weakness present some difficult challenges for policy. At this point many financial market liquidity problems are being addressed through our special lending facilities. These additional tools allow our policy actions with regard to the fed funds rate to focus on broader macroeconomic goals—these are our commitment to price stability and sustainable growth.

*The views presented here are my own, and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.